Morningstar Advocates Refining the Definition of Clean Shares

As a follow up to Morningstar’s recent response to the Department of Labor’s (DOL) request for
information on the fiduciary rule implementation process, the firm has published an infographic aimed at helping retirement plan professionals
answer the crucial question, “How clean are my funds?”

“As we argued in our comment letter, while clean shares have
the potential to benefit investors, the DOL must get the details around promoting
and defining these shares,” the firm tells PLANADVISER. “If regulators assume
that clean shares with sub-TA fees and other kinds of revenue sharing are the
same as the cleanest shares without them, they will be endorsing products that
can have embedded conflicts of interest.”

Morningstar explains it has “urged the Labor Department to
proceed cautiously in using clean shares as a new exempted class for the
fiduciary rule, and told the SEC that the definition in Section 22(d) may not
protect investors from other potential conflicts.”

Aron Szapiro, director of policy research at Morningstar,
adds that “opaque fees and conflicts of interest can hurt investors’ progress
toward their goals, which is why Morningstar has created these guidelines for
the cleanest share classes.”

Szapiro notes there is general agreement that clean
shares will not have front-end loads or 12b-1 fees, which are those used to
pay for a mutual fund’s distribution costs. When this is the case, investors will pay an externalized fee for advice—that
is, the broker or adviser charges it directly to a client.

“But,
there is disagreement about whether clean shares should include sub-transfer
agency fees, or sub-TA fees, and other kinds of revenue sharing,” Szapiro says. “A big part of
the definition depends on what we expect clean shares to do and how much
protection we think they give investors from conflicted advice on their own. As
we’ve told the regulators, there is promise and peril in embracing clean
shares.”

The upshot of Morningstar’s analysis is that clean shares “have
the potential to benefit investors by removing perverse incentives for
financial advisers that sell the funds to enrich themselves rather than their
clients. By forcing mutual funds to compete on merit as advisers recommend
lower-cost, higher-returning funds rather than funds that are most lucrative
for the adviser, clean shares could dramatically improve investors’ experiences
and their outcomes.”

But, Szapiro continues, there is danger if regulators don’t grasp the key differences involved in sub-TA fees and other kinds of revenue sharing. These kinds of
third-party payments obscure business relationships that can push a firm to
sell one mutual fund over another. These back-door payments will elevate the
conflicts of interest from the adviser level to the firm level, and add opacity
to the way mutual funds are bought and sold.”

Morningstar ultimately argues for a cautious and sophisticated
approach: “There may be good reasons to use arrangements with revenue sharing
or sub-TA fees. For instance, some have argued that sub-TA fees can reduce the
costs for accounting. We know that someone has to pay for the services the
transfer agency provides. However, we believe that a clean-share structure that
adds these payments from the mutual fund to a distributor—as opposed to a third
party that has no relationship to the sellers of the fund—requires additional
scrutiny to ensure investors are getting best-interest advice. Regulators
should not assume that such arrangements eliminate conflicts of interest.”